FRANKLIN WIRELESS CORP — Interim / Quarterly Report 1999

Feb 5, 1999

1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q ------------ [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER PERIOD ENDED DECEMBER 31, 1998 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 0-11616 FRANKLIN TELECOMMUNICATIONS CORP. (Exact Name of Registrant as Specified in its Charter) ---------------

733 Lakefield Road, Westlake Village, California 91361 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (805) 373-8688 --------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes[ X] No [ ] Indicate the number of shares outstanding of each of the issuer's class of common stock, as of the latest practicable date:

2 Index Franklin Telecommunications Corp. Part I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets - December 31, 1998 (Unaudited) and June 30, 1998 Consolidated Statements of Operations (Unaudited) Three months and six months ended December 31, 1998 and 1997 Consolidated Statements of Cash Flows (Unaudited) Six months ended December 31, 1998 and 1997 Notes to Consolidated Financial Statements (Unaudited) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Part II. OTHER INFORMATION Item 1. Legal Proceedings Item 2. Changes in Securities Item 3. Defaults Upon Senior Securities Item 4. Submission of Matters to a Vote of Security Holders Item 5. Other Information Item 6. Exhibits and Reports on Form 8-K 3 Item 1. Financial Statements FRANKLIN TELECOMMUNICATIONS CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1998 (UNAUDITED) AND JUNE 30, 1998

The accompanying notes are an integral part of these financial statements. 4 FRANKLIN TELECOMMUNICATIONS CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS AND SIX MONTHS ENDED DECEMBER 31, 1998 AND 1997 (UNAUDITED)

The accompanying notes are an integral part of these financial statements. 5 FRANKLIN TELECOMMUNICATIONS CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED DECEMBER 31, 1998 AND 1997 (UNAUDITED)

The accompanying notes are an integral part of these financial statements. 6 FRANKLIN TELECOMMUNICATIONS CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED DECEMBER 31, 1998 AND 1997 (UNAUDITED) (CONTINUED) SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES. During the six months ended December 31, 1998, the Company completed the following: o Equipment valued at $500,000 that was prepaid at June 30, 1998 was delivered to the Company. o The Company issued 3,151,740 shares of common stock upon the conversion of 325 shares of its Series C preferred stock. o The Company sold equipment with a net book value of $16,000 and the trade name "Malibu Internet Services" to an individual in exchange for a note receivable of $55,000. The accompanying notes are an integral part of these financial statements. 7 FRANKLIN TELECOMMUNICATIONS CORP. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS NOTE 1--GENERAL AND SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES Business and Organization Franklin Telecommunications Corp. ("Franklin") and its subsidiaries (collectively the "Company") manufacture and distribute data and telephony communications, access and connectivity products for IP Telephony networks, T-1 and X.25 wide-area networks and provide IP Telephony and Internet services through its majority-owned subsidiary, FNet Corp. ("FNet"). FNet has had limited operations to date. The Company's customers are located predominantly in the United States, Canada, Australia, South America and parts of Europe in a wide range of industries including financial services, government, telephone services and manufacturing. Basis of Presentation The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all normal, recurring adjustments considered necessary for a fair presentation have been included. The financial statements should be read in conjunction with the audited financial statements included in the Company's annual report on Form 10-K for the fiscal year ended June 30, 1998. The results of operations for the three months and six months ended December 31, 1998 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 1999. Principles of Consolidation The accompanying consolidated financial statements include the accounts of Franklin Telecommunications Corp. and its wholly-owned or majority owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Loss Per Common Share For the three month and six month periods ended December 31, 1998 and 1997, the Company adopted SFAS No. 128 "Earnings per Share." Basic loss per share is computed by dividing loss available to common shareholders by the weighted-average number of common shares outstanding. Diluted loss per share is computed similar to basic losses per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. Common stock equivalents have been excluded from the aforementioned computations as their effect would be anti-dilutive. 8 Income Taxes The Company accounts for income taxes under the asset and liability method of SFAS 109. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is required when it is less likely than not that the Company will be able to realize all or a portion of its deferred tax assets. Recently Issued Accounting Pronouncements SFAS 130, "Reporting Comprehensive Income" issued by the Financial Accounting Standards Board is effective for financial statements with fiscal years beginning after December 15, 1997. Earlier application is permitted. SFAS 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The Company does not expect adoption of SFAS 130 to have a material impact, if any, on its financial position or results of operations. The Financial Accounting Standards Board issued SFAS 131, "Disclosures about Segments of an Enterprise and Related Information," effective for fiscal years beginning after December 15, 1997. SFAS 131 requires a company to report certain information about its operating segments including factors used to identify the reportable segments and types of products and services from which each reportable segment derives its revenues. The Company does not anticipate any material change in the manner that it reports its segment information under this new pronouncement. In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Post Retirement Benefits." This statement is not applicable to the Company. In June 1998, The FASB issued SFAS No.133, "Accounting for Derivative Instruments and Hedging Activities." This statement established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities and is effective for fiscal years beginning after June 15, 1999. Management believes that SFAS No. 133 will not have an effect on the Company's financial statements. SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held by a Mortgage Banking Enterprise," was issued in October 1998. This statement is not applicable to the Company. NOTE 2--INVENTORIES Inventories consisted of the following:

NOTE 3--CONTINGENCIES Legal Proceedings On July 28, 1997 the Company was named as a defendant in an action brought by AT&T Corp. ("AT&T") against Connect America, a reseller of "800" number service, its officers and affiliates, and several Internet Service Providers, 9 including the Company. The action was brought in the U.S. District Court for the Central District of California. In general, the complaint alleges that Connect America and its officers fraudulently acquired 800 numbers from AT&T, failed to pay for them, and resold them to the Company and the other Internet Service Providers on a "flat rate" basis, notwithstanding the fact that AT&T's charges for 800 service are typically based on time utilized. The claims against the Company and the other Internet Service Providers are based on unjust enrichment, on the theory that the Company and the other Internet Service Providers knew or should have known that flat rate 800 service was unavailable. The Company settled the matter in December 1998. NOTE 4--RECENT SALE OF EQUITY SECURITIES During the three months ended December 31, 1998, the Company issued 1,804,218 shares of common stock upon the conversion of 167 shares of Series C Convertible Preferred Stock. The Company did not receive any proceeds from this conversion. During the three months ended December 31, 1998, the Company sold and issued 570,000 restricted shares to the Company's Chief Executive Officer, at $.35 per share. The issued shares are subject to a one year holding period. During the three months ended December 31, 1998, the Company issued 92,795 restricted shares, in lieu of salaries for employees, at $.35 per share. The issued shares are subject to a one year holding period. NOTE 5 - NOTES PAYABLE TO OFFICER Effective December 31, 1998, the Company's Chief Executive Officer agreed to consolidate all notes payable and accrued interest owed to the CEO by the Company into one single note. Changes to the note include no interest charges from January 1, 1999, onward, removal of all security interest in the Company's assets and elimination of previous stock conversion features. 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW Franklin Telecommunications Corp. (the "Company") designs, manufactures and markets high speed communications products and subsystems. The products are marketed through original equipment manufacturers ("OEMs") and distributors, as well as directly to end users. In addition, through its majority-owned subsidiary, FNet, the Company is a provider of Internet access and services, including Internet telephony, to businesses and individuals. The Company is a California corporation formed in 1981. Forward-looking statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations, including statements regarding the Company's entrance into the Internet business, newly introduced products, development of "telephone-to-telephone" service capabilities over the Internet, net sales, gross profit, operating expenses, other income and expenses, liquidity and cash needs and the Company's plans and strategies are all based on current expectations, and the Company assumes no obligation to update this information. Numerous factors could cause actual results to differ from those described in the forward-looking statements. The Company has re-focused its business over the past two years from manufacturing primarily LAN and WAN products to providing telecommunications and Internet products and services. Beginning in the year ended June 30, 1998 and continuing in the three months and six months ended December 31, 1998, the Company has begun to generate revenues from these new business lines. Sales had been declining for the Company's existing hardware products during the previous years, while the newly developed hardware products and Internet services were not yet ready for market. Demand for the Company's new products, including the Data Voice Gateway and D-Mark Channel Bank hardware product lines are now coming into fruition. FNet is in the nature of a new business venture; accordingly, it can be expected that its future operating results will be subject to many of the risks inherent in establishing a new business enterprise. There can be no assurance, therefore, that FNet will be able to achieve or sustain profitability in future periods or that the Company's investment of resources into it will be repaid. FNet is now beginning to produce revenues from its international next generation IP Telephony network. The Company's D-Mark Channel Bank terminates a digital T1 telephone line from the local telephone company and channelizes it into 24 analog data/voice lines for either modems, faxes, or telephones. With the declining cost of T1 digital lines, the Company believes that the D-Mark Channel Bank provides an effective, cost saving solution for companies using 10 or more phones or modems. The Data Voice Gateway, or DVG, is a further evolution of the D-Mark, which adds the capability of transmitting voice and fax traffic over the Internet and Frame relay circuits. The Company has several other products under various stages of development, which have at their roots DVG technology. Many of these products will be introduced over the coming year. As with any new line of business, there can be no assurance that the Data Voice Gateway and D-Mark Channel Bank and other newly developed communications products will sustain widespread market acceptance or be profitable. In addition, there can be no assurance that new hardware products and services developed by others will not render the Company's hardware products and services noncompetitive or obsolete. RESULTS OF OPERATIONS Three Months Ended December 31, 1998 Compared To Three Months Ended December 31, 1997 Net Sales. Net sales increased by $956,000, or 337%, from $284,000 in the three months ended December 31, 1997 to $1,240,000 in the three months ended December 31, 1998. The increase is due both to increased DVG hardware systems sales and increasing telephone revenue from the Company's subsidiary FNet. The revenue mix for the three months ended December 31, 1998 consisted of 23% Telephone and Internet services revenue and 77% hardware product sales. 11 Gross Profit. Gross profit decreased as a percentage of net sales to 34% for the three months ended December 31, 1998, from a gross profit of 43% of net sales for the corresponding period of 1997. The gross profit percentage decrease can be attributed to increased infrastructure costs for the Company's subsidiary FNet. FNet has been building out facilities and capacity in anticipation of future services revenue. Hardware margins remain high, reaching 47% for the three months ended December 31, 1998. Operating Expenses. Operating expenses increased by $785,000, or 77%, from $1,024,000 in the three months ended December 31, 1997 to $1,809,000 in the three months ended December 31, 1998. The increase is attributable to increased product development costs for hardware products under development, costs in developing the Internet and telephony services infrastructure, increased sales and marketing efforts, and costs in enhancing the general and administrative infrastructure. Other Income (Expense). Interest income decreased by $35,000 , or 53%, from $66,000 in the three months ended December 31, 1997 to $31,000 in the three months ended December 31, 1998, due to reduced cash balances available to earn interest. Interest expense decreased by $1,000, or 7%, from $14,000 in the three months ended December 31, 1997 to $13,000 in the three months ended December 31, 1998, due primarily to a reduction in loans from an officer of the Company. Other income (expense) changed by $18,000, from an expense of $17,000 in the three months ended December 31, 1997 to income of $1,000 in the three months ended December 31, 1998, due to various non operating items. Six Months Ended December 31, 1998 Compared To Six Months Ended December 31, 1997 Net Sales. Net sales increased by $1,645,000, or 312%, from $528,000 in the six months ended December 31, 1997 to $2,173,000 in the six months ended December 31, 1998. The increase is due both to increased DVG hardware systems sales and increasing telephone revenue from the Company's subsidiary FNet. The revenue mix for the six months ended December 31, 1998 consisted of 25% Telephone and Internet services revenue and 75% hardware product sales. Gross Profit. Gross profit increased as a percentage of net sales to 41% for the six months ended December 31, 1998, from a gross profit of 25% of net sales for the corresponding period of 1997. The gross profit percentage increase can be attributed to increased sales of higher margin hardware products. Telephone and Internet services produced a relatively low margin during the same period due to increased infrastructure costs for the Company's subsidiary FNet. FNet has been building out facilities and capacity in anticipation of future services revenue. Operating Expenses. Operating expenses increased by $1,425,000, or 71%, from $1,994,000 in the six months ended December 31, 1997 to $3,419,000 in the six months ended December 31, 1998. The increase is attributable to increased product development costs for hardware products under development, costs in developing the Internet and telephony services infrastructure, increased sales and marketing efforts, and costs in enhancing the general and administrative infrastructure. Other Income (Expense). Interest income increased by $25,000, or 38%, from $66,000 in the six months ended December 31, 1997 to $91,000 in the six months ended December 31, 1998, due to increased cash balances available to earn interest over a longer period. Interest expense decreased by $1,000, or 7%, from $14,000 in the three months ended December 31, 1997 to $13,000 in the three months ended December 31, 1998, due primarily to a reduction in loans from an officer of the Company. Other income increased by 100%, from $-0- in the six months ended December 31, 1997 to $4,000 in the six months ended December 31, 1998, due to various non operating items. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents and net working capital totaled $2,724,000 and $2,037,000, respectively, as of December 31, 1998. The primary source of cash was net proceeds generated from equity financings. The Company has relied on sales of new shares and the exercise of warrants and options to fund operations for an extended period of time. The Company received $10,150,000 and $201,000 in equity financing, for the year ended June 30, 1998, and the six months ended December 31, 1998, respectively. Its subsidiary, FNet, raised $398,000 for the year ended June 30, 1998 and $18,000 for the six months ended December 31, 1998. FNet has continued to experience losses, due to the growth nature of the Internet services business and development of the IP Telephony business. In addition to the equity financing 12 described above, the Company's President has deferred portions of his compensation, and has on occasion converted debt to equity in order to preserve the Company's cash. The Company anticipates that its primary uses of working capital in future periods will be for increases in product development, expansion of its marketing plan, development of new branch offices and funding of increases in accounts receivable. The Company believes that existing cash and cash equivalents, cash flow from operations and cash raised through private placements will be sufficient to meet the Company's presently anticipated working capital needs for at least the next 13 months. To the extent the Company uses its cash resources for acquisitions, the Company may be required to obtain additional funds, if available, through borrowings or equity financings. There can be no assurance that such capital will be available on acceptable terms. If the Company is unable to obtain sufficient financing, it may be unable to fully implement its growth strategy. YEAR 2000 COMPLIANCE The "Year 2000" issue concerns the potential exposures related to the possible automatic generation of business and financial misinformation resulting from the application of computer programs which have been written using two digits, rather than four, to define the applicable year of business transactions. When the year 2000 begins, programs with such date-related logic will not be able to distinguish between the years 1900 and 2000, potentially causing software and hardware to fail, generating erroneous calculations or presenting information in an unusable format. The Company is dependent on multiple computer servers and the third-party computer programs running on them to provide data in support of its accounting and engineering functions. Also, FNet's ability to route its traffic in a cost effective manner, to deliver a material portion of its services, to properly obtain payment for such services, and/or to maintain accurate records of its business and operations, could be substantially impaired until such issue is resolved. The Company's plan for year 2000 compliance includes the following phases: (i) conducting a comprehensive inventory of the Company's internal systems, including information technology systems and non-information technology systems (which include switching, billing and other platforms and electrical systems) and the systems acquired or to be acquired by the Company from third parties, (ii) assessing and prioritizing any required changes, upgrades, or enhancements, (iii) resolving any problems by repairing or, if appropriate, replacing the non-compliant systems, (iv) testing all remediated systems for Year 2000 compliance, and (v) developing contingency plans that may be employed in the event that any system used by the Company or FNet is unexpectedly affected by a previously unanticipated problem relating to the Year 2000. In recognition of the potential year 2000 problem, the Company began a program to replace any of its existing communications, engineering and accounting software that is not year 2000 compliant with new software that is warranted by its vendors as being year 2000 compliant. The software replacement program has been completed, and the cost was not material. The Company has relationships with various third parties on whom it relies to provide goods and services necessary for the manufacture and distribution of its products. These include suppliers and vendors. As part of its determination of year 2000 readiness, the Company has identified material relationships with third party vendors and is in the process of assessing the status of their compliance through the use of informal inquiries and review of hardware and software documentation. The Company expects this process will be complete by the first quarter of 1999 and the cost will not be material. The components purchased by the Company in connection with the manufacture of its products are available through numerous independent sources. Due to the broad diversification of these sources, the risk associated with potential business interruptions as a result of year 2000 non-compliance by one or more sources is not considered significant. It is anticipated that the steps the Company has taken and is continuing to take to deal with the year 2000 problem will reduce the risk of significant business interruptions, but there is no assurance that this outcome will be achieved. Failure to detect and correct all internal instances of non-compliance or the inability of third parties to achieve timely compliance could result in the interruption of normal business operations which could, depending on its duration, have a material adverse 13 effect on the Company. In particular, FNet may experience problems to the extent that other telecommunications carriers to which the Company sends traffic for termination are not Year 2000 compliant. FNet's ability to determine the capacity of these third parties to address issues relating to the Year 2000 problem is necessarily limited. To the extent that a limited number of carriers experience disruptions in service due to the Year 2000 issue, the Company believes that it will be able to obtain service from alternate carriers. However, the Company's ability to provide certain services to customers in selected geographic locations may be limited. There can be no assurance that such problems will not have a material adverse effect on the Company. 14 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On July 28, 1997 the Company was named as a defendant in an action brought by AT&T Corp. ("AT&T") against Connect America, a reseller of "800" number service, its officers and affiliates, and several Internet Service Providers, including the Company. The action was brought in the U.S. District Court for the Central District of California. In general, the complaint alleges that Connect America and its officers fraudulently acquired 800 numbers from AT&T, failed to pay for them, and resold them to the Company and the other Internet Service Providers on a "flat rate" basis, notwithstanding the fact that AT&T's charges for 800 service are typically based on time utilized. The claims against the Company and the other Internet Service Providers are based on unjust enrichment, on the theory that the Company and the other Internet Service Providers knew or should have known that flat rate 800 service was unavailable. The Company settled the matter in December 1998. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable ITEM 5. OTHER INFORMATION Not applicable ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 27.1 Financial Data Schedule (b) Reports on From 8-K None 15 SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. FRANKLIN TELECOMMUNICATIONS CORP. By: /s/ FRANK W. PETERS ------------------------------------- Frank W. Peters Chief Executive Officer By: /s/ THOMAS L. RUSSELL ------------------------------------- Thomas L. Russell Chief Financial Officer Dated: February 5, 1999 16 EXHIBIT INDEX